SEC Staffing Up for a New Era of Crypto Control

On May 3, 2022, to address issues relating to unregulated digital assets, the Securities and Exchange Commission (SEC) announced the hiring of new investigative agents, including investigative staff attorneys, trial lawyers, and fraud analysts, to crack down on bad actors in the crypto space. The growing complexity of cryptocurrencies has led the SEC to alter its cybersecurity organization and focus. This shift prompted the SEC to change the name of its previous “Cyber Unit” to the “Crypto Assets and Cyber Unit.” The renamed unit was created to help ensure that investors in cryptocurrency markets are protected from regulatory risk related to digital assets and will focus on investigating securities law violations.

Cryptocurrencies are decentralized digital currencies tracked and maintained through a blockchain. A blockchain is a digital ledger of transactions that is duplicated and distributed across an entire network of computer systems. When a transaction occurs, it is digitally recorded on a distributed ledger that acts as a continuously updated, decentralized, and permanent record of all transactions that occur with a specific cryptocurrency. This system ensures that no one person holds the central ledger of all transactions and it instead exists in multiple locations simultaneously, allowing for independent verification and lack of centralized control. As of May 26, 2022, the total global market capitalization of all cryptocurrencies is approximately $1.27 trillion, which would constitute the world’s 15th-largest economy by gross domestic product.

As discussed in our previous blog posts, When Is a Crypto Asset a “Security,” and Why Does That Matter? (Part I) and (Part II), the SEC has indicated that it may take the view that many cryptocurrencies are investment contracts under the Howey test, requiring the issuance of these digital assets to comply with the federal securities laws. Additionally, some market watchers believe that investor confidence in these digital assets has suffered recently, following the collapse in value of certain cryptocurrencies, including the algorithmic stablecoin TerraUSD (UST).

Stablecoins are cryptocurrencies whose value is designed to be pegged to a sovereign’s currency, a commodity, or financial instruments. Stablecoins aim to provide an alternative to the high volatility of the most popular cryptocurrencies. Algorithmic stablecoins, like UST, depend on algorithms, which set the rules for balancing their own supply and demand.^[1] UST argued that its business model would offer stability, promising to maintain a one-to-one peg with the U.S. dollar.^[2] However, on May 9, 2022, UST was unable to maintain its one-to-one peg with the U.S. dollar and it began to freely float, which prompted a collapse in value, dropping from a market capitalization of $19 billion to $1 billion in less than four days. UST’s crash has called into question to the credibility of algorithmic stablecoins.

The SEC believes that the expansion of the Crypto Assets and Cyber Unit will be a step in the right direction in helping to better protect investors in volatile cryptocurrency markets. Nevertheless, Hester Peirce, an SEC Commissioner, opined, “We’re not allowing innovation to develop and experimentation to happen in a healthy way, and there are long-term consequences of that failure.” Many participants in the market blame this stifling of innovation and experimentation on lawmakers and have called on Congress for regulatory clarity.

On June 7, 2022, Senators Cynthia Lummis and Kirsten Gillibrand introduced the Responsible Financial Innovation Act, the first piece of federal legislation to provide a comprehensive framework governing digital assets. While this bill is a step toward clarification in the digital asset space, its likelihood of passage and the final form that it might take is unclear. For the foreseeable future, cryptocurrencies are likely to remain “regulated by enforcement” and players in the crypto industry should brace themselves for increased investigations and enforcement activity. Capital Markets Watch will continue to monitor developments in this market and provide updates.

Winston & Strawn Summer Associate Pete Staviski also contributed to this blog post.

---

^{[1] Algorithmic stablecoins use rebase tokens to algorithmically adjust their supply to control their price. Rebase tokens are usually pegged to another asset, but instead of using reserves to maintain their peg, rebase tokens automatically burn tokens in circulation or mint new tokens.}

^{[2] A one-to-one peg with the U.S. dollar establishes the exchange rate. The value of the cryptocurrency will mirror fluctuations in the value of the currency to which it is pegged.}